Tuesday, May 17, 2011

Merrill's Fund Managers Are Fading Or Risking

The potential summer surprisesThe May FMS sees investors questioning global growth (in a re-run of summer 2010) but enjoying ample liquidity that keeps risk appetite high. A stand-off has ensued with little change in allocation across asset classes but some switching within asset classes, typified by defensive rotation within equities. The summer surprises are either growth to the upside or liquidity disappointing as QE2 ends.Growth expectations are fallingOnly a net 10% of investors expect stronger global economic growth in the next 12m, down from 58% in Feb. This is easing inflation concerns, albeit marginally, with a net 61% seeing higher inflation down from 75% in March.Risk appetite resilientThree-quarters of the panel expect no Fed rate rise before 2012 and so risk appetite remains firm. Hedge funds are risk-on with 1.53x gearing the highest since Nov-07. Cash balances rose to 3.9% up from 3.7%, but remain low. Our risk appetite indicator eased to 43 but is well above the average of 40.EU debt the tail risk but watch ChinaGrowth fears see EU debt issues again ranking as the main investment risk. A slightly lower EU growth outlook (49 vs. 52) is being offset by US resilience and a rebound in Japan sentiment (74 vs. 42). A bigger concern is the deeper decline in China optimism with a net 28% seeing weaker growth compared to 15% in March.Asset allocation: very modest changeAsset allocation saw modest rotation into bonds (48% UW from 58%) funded by lower commodities (12% OW vs. 24%) and equities (41% OW vs. 50%). GEM regains its position of most preferred region (29% OW vs. 22%) replacing US (26% OW). Consensus is UW Europe (-1%) and Japan (-17%). USD sentiment (48% undervalued) is one of the highest readings since 2002.Sector rotation: defensive rotationSharp falls in energy (to 19% OW from 40%) and materials (2% UW from 17% OW) accompanied a sharp defensive rotation into staples (8% OW from 6% UW), pharma and telecoms. Banks are once again the most unpopular sector (26% UW down from 15%) with technology by far the most popular (35% OW).How to trade the risk scenariosIf the summer sees stronger-than-expected growth: long banks, short pharma; long commodities, short bonds. If the summer sees weaker liquidity: long bonds, short equities; long US$, short EM.

Click on chart to enlarge, courtesy of BofA Merrill Lynch.

While there is still room for "feel good" short-term rally, it is more likely to see weaker liquidity over summer ...